Subject: Economics

Context

Inflation has now remained above the RBI’s upper tolerance limit of 6 per cent for four months in a row.

Broad based inflation

• The second-order impact of higher fuel prices is also visible as inflation in transport and communication surged to nearly 11 per cent, from 8 per cent in the previous month.
• The latest data also indicates that inflation is becoming broad-based. 
• With demand rebounding, the pass-through of higher input costs is also gaining momentum.
• Considering that demand for goods recovered faster than services, goods producers passed on input costs to consumers.
• But as services recover, there will be greater pass-through of prices to consumers in the coming months.
• While there may be a slight moderation, inflation is expected to remain above the RBI’s threshold of 6 per cent in the coming months.
• The Ukraine conflict continues to impact markets for foodgrains and vegetable oils.
• Rising fertiliser prices are likely to push up farmers’ production costs, leading to high food prices.
• While the government has extended price support through higher subsidies, if this will be enough to cool prices needs to be seen.

Inflation targeting by the RBI

• With sticky crude oil prices and continuing supply-side disruptions amplified by the Covid-induced lockdowns in China, the RBI has rightly reverted its focus on inflation targeting.
• This is needed as central banks around the world are pursuing tight monetary policies to counter inflation.
• The US Fed followed its 25 basis points hike by another 50 basis points rise in May.
• These will be followed by hikes of similar magnitude in the coming months.
• In its April policy, the RBI announced the withdrawal of excess liquidity but did not raise the policy rate.
• Rate hikes by RBI: The RBI is now likely to respond with aggressive rate hikes to prevent the price spiral from getting entrenched.
• The continued strength of the dollar index and sharp rupee depreciation in the last few days could impose further pressure on prices through higher imported inflation.
• Withdrawal of liquidity support: In addition to calibrated rate hikes, the RBI needs to fast-track the withdrawal of the ultra-accommodative liquidity support provided during the pandemic.

Implications

• Discretionary spending: Rising inflation will cut back discretionary spending and adversely impact consumption that had only just started picking up.
• Recession concerns: There are concerns about a recession in advanced economies as rising prices have started manifesting in a decline in purchasing power and a fall in consumer sentiments.
• The demand destruction could trigger a moderation in prices.
• Base metals prices have eased from the peak seen in the last few months.

Conclusion

Monetary policy support needs to be accompanied by fiscal support measures. The policy response will have to be tailored to the evolving geopolitical situation and the paths of commodity and food prices while balancing the imperatives of fiscal consolidation.

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Context

The Reserve Bank of India (RBI) last week raised both policy rates and cut back liquidity in a surprise inter-meeting decision. The forcefulness and urgency of the policy shift have been seen as a signal of the RBI’s renewed commitment to fighting inflation via aggressive monetary tightening in the coming months.

How do higher inflation rates slow inflation?

• It is true that a large swathe of the global economy is in the throes of runaway inflation and that in many of these economies tightening monetary and fiscal policies is the right response.
• Initial conditions: But initial conditions matter as do the specific drivers of inflation.
•  There are typically three ways in which higher inflation rate slows inflation.

1] Lowering inflationary expectations

• Suppose one believes that because a central bank has not tightened enough, future inflation will be higher.
• In that case, the obvious response is to bring forward future consumption and investment to the present, thereby adding to demand and fueling current inflation further.
• So, in principle, the central bank by credibly committing to bringing down inflation through aggressive current actions can bring down expectations of future inflation. 
• It won’t work in India: This is a very potent conduit of monetary transmission in developed markets, where there is a wide variety of inflation-hedging instruments, as well as in some emerging markets — Brazil, for instance —where inflation-indexation is widespread.
• However, there is little empirical evidence that this channel works in India, even weakly.

2] Exchange rate channel

• Higher interest rates attract foreign capital that appreciates the currency, lowering import prices and, in turn, inflation.
• Again, this is a powerful mechanism in Latin America and Central Europe, where bond flows — that are sensitive to interest rate differential —dominate capital movements and the import content of the consumer basket is large.
• Will it work in India? This is not the case in India and, in any event, for this to work it would require extreme rate hikes in the country, given the anticipated aggressive tightening by the US Fed.

3] Curbing credit growth

• Raising both the cost of borrowing as well as its availability (for example, by increasing the cash reserve ratio) reduces credit growth, lowering demand, GDP growth and, eventually, inflation.
• It works well in India: This is the credit transmission by which higher interest rates dampen inflation and it works well in India.
• How much of today’s price increase is credit-driven? Even a cursory glance at bank balance sheets would suggest that credit growth is just treading water.
• Having recovered from being negative in mid-2021, real credit growth is running just around 2 per cent.

Comparison with inflation-monetary policy dynamics of 2010-11

• Back then, real GDP growth was clocking over 10 per cent per quarter, nominal credit growth 20-25 per cent, and real credit growth over 10 per cent.
• Inflation was unambiguously driven by an overheated economy and fueled by runaway credit.
• In the event, the RBI assessed the drivers of inflation to be originating from the supply side — higher food and commodity prices — and moved at a glacial pace, such that even after 12 rate hikes inflation remained in double digits for much of that period.
• Faced with a potential US Fed tightening in 2013, India found itself in a near-crisis situation.
• Today things are different. Much of the inflation is driven by global food and commodity prices.
• Despite the languishing private demand, core inflation remains high.
•  But this has been the case for much of the last two years, strongly suggesting that the domestic supply chain disruptions in manufacturing and services, especially at the informal level, haven’t been repaired fully.
• The reason why firms locate in the informal sector in the first place is because of lower transaction costs, so when parts of the supply chain shift to the higher-cost formal sector, it shows up as inflation during the transition before increased scale of production and efficiency bring down the cost over time.
• None of these factors is affected much by higher lending rates. 
• So the burden of taming inflation by tightening monetary policy will fall largely on lower credit.
• There is clearly a case to remove the extraordinary monetary support provided during the pandemic.

Conclusion

The RBI had misread the drivers of inflation badly in 2010-11. Hopefully, it won’t repeat that mistake this time.

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